We used to have fun commenting about the bond market, including Treasuries, Mortgages, Municipals, and Corporates. But that was before the dark times. Before deleveraging.
Contact the Author: accruedint at gmail.com

Tuesday, January 15, 2008

You will seldom hear a more vocal defender of capitalism than myself. I tend to be for allowing the market to find its own way, and keeping the government as far away from commerce as possible.

Capitalism works on a few simple principles, which I'm sure I hardly need to recount to AI readers. But the most critical and most fundamental principle is that of incentives. Capitalism assumes that human beings react to incentives. If a system is devised which incentivizes people to work toward socially beneficial goals, then people will naturally perform socially beneficial activities. Hence why people strive to invent new products, devise new production processes, discover new medicines, etc. The dream of striking it rich compels people to pursue all sorts of positive achievements, and mankind has certainly benefited from these pursuits.

In some corners, however, the modern incarnation of Smith's capitalism has become divorced from its core principles. Take Countrywide CEO Angelo Mozilo. He founded the company in 1969 and grew it into one of the largest mortgage underwriters in the U.S. For his success, Mozilo has certainly been well-rewarded over the years.

Today, of course, Countrywide is in serious danger of bankruptcy. The mortgage business is going through a historically difficult period, and if it weren't for a recently announced merger with Bank of America, Countrywide's future as a going concern would be very much in doubt. We could debate the degree to which Mozilo is personally responsible for Countrywide's sudden collapse. But what cannot be denied is that under Mozilo's leadership, Countrywide has destroyed shareholder value over the last 10 years.

And yet Mozilo looks to walk away with a gigantic pay day. According to Bloomberg News, Mozilo could walk away with as much as $84 million assuming the merger goes through. There are some circumstances in which the number could be lower, or even zero. Regardless, the mere possibility that Mozilo would enjoy such a payout creates a perverse incentive.

In any free market system, there will be failures. The dream of riches has to have a downside. With the potential for great success must also come the potential for great failure. Without a penalty for failure, economic agents would be incentivized to take inordinate risks. In private companies, this risk is naturally managed. Small business owners normally must put up their own capital, or borrow against existing assets, such as their homes. Obviously an entrepreneur believes in his new business idea if s/he is willing to mortgage his home and life savings to fund it. Whether the business winds up succeeding or not, the incentives are for the entrepreneur to create value.

Mozilo may have been an entrepreneur once upon a time, but today he's the CEO of a very large public corporation. He knew his company had a large servicing portfolio which would have value to a larger financial institution, regardless of how the rest of his business was performing. He had a long standing relationship with Bank of America, and indeed was supposedly discussing a merger late in 2006. Mozilo could rationally conclude that he'd be able to sell Countrywide, whether to Bank of America or some other institution, in the event Countrywide ran into serious trouble.

With this in mind, what were Mozilo's incentives in recent years? Countrywide's shares had been languishing in the upper 30's for most of 2005, 2006 and early 2007. No doubt Mozilo's personal stock and stock options were not gaining much during this period. Let's be particularly cynical and suppose that Mozilo saw that sub-prime lending had gotten out of hand, and many bad loans were being made. If he was motivated primarily by personal wealth accumulation, then he was probably wise to just keep making those bad loans. After all, the only way Countrywide's share price was going to rise, and create wealth for Mozilo himself, was for the company to grow EPS. In order to do that, they had to keep making loans. Pulling back and tightening credit standards would only slow revenue.

So if Mozilo wanted to grow his personal wealth by pushing the share price higher in the short-term, he would do well to bet heavily on good times. All the while knowing that if it all went to hell, he would just sell the company and collect his exit pay.

Now, we don't actually know what Angelo Mozilo thought about the housing market in 2005 or 2006. We know what he said publicly, but we'll never know what he really believed in his own mind. Perhaps his motivations were noble, and he was merely wrong about the lending business. Even if that's true, the fact that his incentives were otherwise is a serious problem for modern capitalism.

I don't know what the solution is here. Perhaps it is nothing more than having investors put more pressure on compensation committees to create better incentives. Maybe it means that more businesses should stay private. But the problem of perverse incentives is the biggest single problem facing capitalism today. The sub-prime mess will come and go. This is a bigger problem.

Posted by
Accrued Interest

42 comments:

don
said...

You state:

"If a system is devised which incentivizes people to work toward socially beneficial goals, then people will naturally perform socially beneficial activities."

Could it be that a people who seek to "perform socially beneficial activities" will devise a system in the first place that incentivizes said activities? Could it be that looking at this in either direction is to see that a paradigm restricted to cause/effect misses the true dialectical relationship? Might the world just a little more complex than you assume?

The fault lies with the board of directors. There is nothing wrong with what the executives and others are doing. If you were in their position, you will likely ask to be paid the most for doing the least work (as most workers do).

What needs to happen is that the nominees to the board of directors need to be truly independent and competent. Right now, a lot of those positions are given to `famous people` (like politicians, industry lobbyists, allied lawyers, etc) or to people that management likes (executives in other companies, retired management, etc).

As long as the board of directors scratch each others` back, nothing is going to happen on the compensation front.

It would also help if academia started doing something innovative in human resources. It seems like literally nothing has happened for 30 years (after the great innovation with lower level workers in the 50`s and 60`s). I`m hopeful that academics or some theoreticians develop better compensation systems. Right now, executives make money off stuff that has nothing to do with them (eg. oil executives raking in the money due to high oil prices even though their companies haven`t increased production or efficiencies).

Anyway, I don`t think it`s as big of a concern as you imply. The compensation issue won`t take down the free markets or the capital markets down with it...

I think history will show that some form of "State Capitalism" as practiced by China and Russia, for example, will become the new economic model. The US seems to be in the process of proving that when the government is completely co-opted by the corporation, then the society becomes unstable. Successful countries will be those that nurture and support the positive aspects of capitalism that you speak of but ensure that the corporation remains subservient to the society.

The whole agency problem was discussed during the Enron and Tyco fiascos. Congress joined in and made a bad situation worse by writing Sarbanes Oxley, which creates lots of jobs for attorneys but does absolutely nothing to prevent wide scale looting of public investors.

How many people reading this blog have seen a proxy statement? (hopefully most) Companies send out a lot of paper work- part of which asks the sheep, I mean shareholders, to pick a board of directors. Lets say for example that there are 6 open slots. Guess what? There are 6 people running, so as long as they get one "In Favor" vote, they are in. Unless there is a hostile takeover, guess who picks ALL SIX NOMINEES? Management, aka the CEO. If the guy is smart enough to find the office building, then he is smart enough not to pick anyone who is going to give him a hard time.

Whether these puppets meet the legal definition of "independent" is just another thing for lawyers to litigate over -- the board members are there because the CEO put them there. They are not independent.

Just try to think of a Board of Director nominee who was not approved... Hostile takeover situations are rare, they don't count. Forget about that. When is the last time YOUR company even bothered to tell you the voting results? Like your stupid opinion even mattered!

Probably the only effective thing Joe Average can do is to punish Fidelity (and Janus and Vanguard and Schwab and all the other fund companies). Force your mutual fund company to challenge the board of directors, to challenge management, and (important!) blacklist the companies of any board member who is as asleep at the switch as Countrywide's so obviously was.

Your 100 shares are next to irrelevant. But Fidelity's 8 million shares are enough to ruin a corrupt CEO's day. Guess what? That is YOUR money Fidelity is messing with. You are paying Fidelity to actually manage it-- if they won't do their job, they don't deserve your money. FIRE your mutual fund, and make sure they know it is for negligence.

(BTW- I am picking on Fidelity because I have my money there. The same sentiment applies to all mutual fund companies).

While you are at it, rip your worthless State Governor a new one for not voting the state pension shares.

Make sure every money manager learns (the hard way if needed) that Voting "Whatever management wants" is irresponsible and a breach of fudiciary duty.

If you think this solution is a little aggressive -- just keep in mind that you will pay for your ignorance when you are rotting and neglected in an overcrowded nursing home because your investments weren't important enough to get upset about.

I agree with sivaram & anonymous 9:24 ... with the exception of the latter's 'State Governor' recommendation. Rip him a new one for appointing lackadaisical directors to the State pension board, perhaps.

I agree with your analysis conceptually, but in this particular case Mozilo was already wealthy enough (between $100 millions and low $billions according to the articles I've read) that the comparatively measly $84 million in exit pay can't have had an extreme impact on his behavior and incentives.

($84 million would motivate me a great deal, but if I were already worth a billion dollars it would mean much less to me).

There are many situations like cfc these days in which a ceo/fund manager got paid enormous sums for making terrible bets and inflating incomes over the last 3 years. Not sure how to fix the problem though. But it sure is not to become more like china and russia :).

I think the problem is that so much of CEO incentive plans revolve around short-term stock prices, which encourages short-term gains at the expense of long-term liabilities. The irony is that if you stopped using stock prices as a metric, they probably become more accurate (as the CEO stops trying to manipulate short-term share prices or trying to impress the street).

AI, why is it so difficult to do what Buffett does for exec compensation.. tie it directly to performance, but that performance will be evaluated 5 years down the line when the clear results (and any risk taken on) will be clear.

Pay 'em 300k nominal, I'm fairly certain people won't have too much problem with that. It's the millions and millions of gratuitous exuberance that are in Mozilo's Caymans accounts which are in question.

GAVIN: """AI, why is it so difficult to do what Buffett does for exec compensation.. tie it directly to performance, but that performance will be evaluated 5 years down the line when the clear results (and any risk taken on) will be clear...Pay 'em 300k nominal, I'm fairly certain people won't have too much problem with that."""

What Buffett does is somewhat similar, although not to the same extreme, as what is already happening in the corporate world. Most executives actually have a very low salary (usually $100k to $500k). Most of their compensation comes from incentive plans and performance. Believe it or not, most of the large payouts are actually because they were thought to have improved profits (usually measured by looking at the stock price). A lot of the payouts also have vesting periods of 3+ years so it isn't necessarily due to short-term thinking either.

The BIG difference with Buffett is that he generally buys companies, often medium-sized, where the executives own a huge chunk of the business. That is really what makes it different. Other than that, there is little difference. I'm sure the executives of public corporations that Buffett owns (like Wal-mart, Coca-Cola, USG, etc) make as much as anyone else in other corporations.

When someone owns a big chunk of the business (the businsses that Buffett generally targets), they don't care about their salary since that is just a small component of their wealth. But the vast majority of publicly listed companies aren't like that. So the "Buffett solution" simply cannot be applied.

On another note, the thing to realize is that humans have a habit of ignoring things when everything is rosy, and then harping on matters if they fall apart. If executive compensation is to be improved, people need to criticize those getting large undeserved payouts (for things not of their own doing) during the good times. For example, why don't shareholders don't raise their voice when the CEO of ExxonMobil walks out with probably(?) the largest package in history simply because oil prices went up; or when the CEO of Goldman Sachs makes a lot on uncertain profits (I am not sure that Goldman isn't taking too much risk with their strategies). Until this positive side of the story changes, I don't think the negative side will either...

ANONYMOUS: "I think history will show that some form of "State Capitalism" as practiced by China and Russia, for example, will become the new economic model...Successful countries will be those that nurture and support the positive aspects of capitalism that you speak of but ensure that the corporation remains subservient to the society."

Completely disagree with that! As long as liberal-libertarians like me exist, your suggestion won't fly. You are basically calling for fascism (free markets + strong state).

The countries that you look upon like Russia and China can fall apart any minute. In fact, situation in those countries are FAR WORSE than anything in USA. At least in USA the shareholders choose to pay the executives (and others) the high compensation. In countries like China the shareholders have a small voice.

The same thing goes on in those countries. Instead of the shareholders having control, the state decides who gets rich. There are many millionaires and billionaires being created in Russia and China. Many of them, sadly, are people that the state PICKS!

If you don't believe corruption is even worse when the state has more power, come back to me in 5 years and we'll see...

Realigning the interests of agents and shareholders is not an easy problem to solve. Using shallow and short-term metrics such as EPS is simple but obviously comes with many potential problems as you pointed out. There is no right answer. That's why there are ppl who made a good living designing exec incentive plans (Stern Stewart comes to midn).

Another point you highlight is the importance of reading proxy statements. You'll be amazed how much predictive power the comp plans have on companys' future performance.

Sivaram,I'm afraid you have it exactly backwards. Facism is when the government is owned by and subservient to corporate interests as is the case in the US today. Sure, even in China and Russia the rich get richer, but everyone else does relatively better which is again, the exact opposite of the situation in the US today.

Nope, fascism is when government rules supreme aided by a free market. Nazi Germany and Italy are good examples.

As for your view that China, Russia, et al, have "everyone doing relatively well", let's have this discussion in 3 years. I'll be here and let's see. You don't realize that a huge chunk of the Chinese population are falling behind. Inflation is so rampant that the government is even trying to fix food prices (which is going to result in shortages). What you see in the press is not exactly how the world is. The billionaries in USA are a joke compared to the ones in Russia. At least people like Mozilo built up their company with little government help; the same cannot be said for any of the countries you mention...

When I first read the anonymous post calling for the US to emulate China and Russia, I thought the author was being ironic; but seeing that he continues to maintain the position as serious, he must be answered. The following are notes from an article by Friedrich Pollock, entitled, “State Capitalism: Its Possibilities and Limitations” (1941).

For the article visit this address: http://www.msu.edu/course/phl/421/phl421/spring2001/peterson_1/421Pollock.html.

In this post, let’s get clear on what state capitalism is (most of the writing is taken from the article itself, even when there are no quotations; I apologize for this but when I took the notes they were for myself):

Utility of the term, “state capitalism.”1 state capitalism is the successor of private capitalism2 that the state assumes important functions of the private capitalist3 – that profit interests still play a significant role4 – that it is not socialism

How does it differ from private capitalism1 – Market is deposed from its controlling function to coordinate production and distribution. This is taken over by DIRECT CONTROLS. Trade, enterprise, and labor are subject to governmental interference. The autonomous market the so-called economic laws disappear. 2 – New and old devices are used, including a “pseudo-market,” for regulating and expanding production and coordinating it with consumption. Full employment of all resources is claimed as the main achievement in the economic field. 3 – The state is the power instrument of anew ruling group, which results from the merger of the most power vested interests, top-ranking industrial and business moguls, the higher strata of the state bureaucracy (including military) and leading figures of the victorious party’s bureaucracy.Those who do not belong are objects of domination.4 - Under the democratic form of state capitalism, the state has the same controlling functions, but is controlled by the people. It is based on institutions that prevent the bureaucracy from transforming its administrative position into an instrument of power.

Heritage of the Market System1 - It was medium-sized private enterprise and free trade that led to such development in the 19th century. Today, however, the offspring of prosperity is destroying liberalism: private monopolies and government interference2 - A new system must take the place of the market system It will involve, (a) the coordination of needs and resources, (b) the direction of production, and (c) the distribution(1) a way of defining the needs of society in terms of consumer goods, reproduction of plant, machinery and raw materials, and expansion. (2) allocation of all available resources in such a manner that full employment and utmost satisfaction of the recognized needs are attained (3) coordination and control of all productive processes in order to obtain best performance (4) distribution of the social product.

A New set of rulesThese new rules are based on a combination of old and new means.(1) A general plan gives the direction for production, consumption, saving and investment.(2) Prices are no longer allowed to behave as masters of economic process but are administered in all important section of it.(3) The profit interests of both individuals and groups as well as all other special interests are to be strictly subordinated to the general plan or whatever stands in its place. In Nazi Germany the profit motive is not quite the same as it was before, but profit has not lost entirely its former meaning. (4) In all spheres of state activity (and under state capitalism that means in all spheres of social life as a whole) guesswork and improvisation give place to the principles of scientific management.(5) Performance of the plan enforced by state power so that nothing essential is left to the functioning of laws of the market, or other economic laws. Under private capitalism, all social relations are mediated by the market; men meet each other as agents of the exchange process, as buyers or sellers. One social position is a function of one's income in the size of one's property. It is the profit motive that keeps the economic mechanism of society moving. Contrariwise, under state capitalism men meet each other as commander as act or commanded. The degree to which one can command is a function of one's position in the political setup and only a secondary way upon the extent of one's property. The profit motive is superseded at the power motive.

In the next post, I will turn to the origin of the corporation/government relation to which the debate between Sivaram and Anonymous alludes.

Now returning to the debate and the reason why Anonymous is mistaken. While the influence of corporations on government cannot be denied, we must consider that it was the expansion of the federal government that provided the conditions for such influence. A centralized and large federal government facilitates the influence of particular interests, whether corporate or social, on collective policy. It is for this reason that the solution lies not so much in changing who is at the helm, but in breaking the mothership down into a fleet of smaller ships. Were more power and money in the hands of the states and from the states to localities, the ability of corporations to influence policy would decrease. If you fracture power, you empower individuals. Allow me to close with a passage by Benjamin Constant that I love:

“The omnipotent nation is as dangerous as a tyrant, indeed more dangerous. Tyranny is not constituted by there being few governors. Nor does a large number of governors guarantee freedom. The degree of political power alone, in whatever hands it is placed, makes a constitution free or a government oppressive; and once tyranny subsists, it is all the more frightful if the tyrannical group is large…This doctrine [overextension of political power] creates and then carelessly casts into our human arrangements a degree of power which is too great to be manageable and one which is an evil whatever hands you place it in. Entrust it to one person, to several, to all, you will still find it an evil. You lay the blame on the power-holders and depending on the circumstances, you will have to indict in turn monarchy, aristocracy, democracy, mixed constitutions, and representative government. And you will be wrong. The condemnation must be of the extent of the power and not of those in whom it is vested. It is against the weapon and not the person wielding it we need to rail. There are things too heavy for human hands.”

We might join with Constant and say of Anonymous and those who share his views, “[T]heir wrath has been directed against the wielders of power and not the power itself. Instead of destroying it, they have dreamed only of relocating it.”

It has been well known for many years that the correct way to design a popular lottery is with a concave distribution of prizes:

1) A very few very big prizes, and

2) A great many very small prizes

The reason the peasants don't storm the castle and tear Mr. Mozillo apart and feed him to the dogs is that they can imagine themselves making his pay and living his life...winning the lottery if you will. And they are content with their tiny fraction of the wage lottery while imagining what it would be like to be Mr. Mozillo.

That is the story of American life. It is lived out in the malls of America every day as Americans buy cachet (Abercrombie, etc.) in small quantities and imagine it in big quantities.

It has absolutely nothing whatever to do with the invisible hand.

It has everything to do with P.T. Barnum.

It is the reason why government should be very involved in the economy.

In France, which has the best health care in the world, a financial incentive is paid to women to seek prenatal care while pregnant. Res ipsa loquitur.

anon said..""It is the reason why government should be very involved in the economy.

In France, which has the best health care in the world, a financial incentive is paid to women to seek prenatal care while pregnant.""

France is now having huge problems with it's health care. Just last month there were some drastic changes. You now have to be a permanent resident for 5 years to get it. Even with residency, the deductibles are now so high you now need to have health insurance! And trying to get an appointment with a gynecologist is very hard. Not to mention the high tax rates required in France to pay for this state controlled health care mess.

When the government stays out of the health care industry, evidence shows that the health care situation improves immensely. ABC reporter John Stossel has been doing a lot of quality reporting on this.

What happened to our great American Society? There are only two clases these days the ultra rich that control over 90-95% of wealth in this country and the lower class. The rich keep getting richer while the lower class salries cannot keep up with the rising inflation.This has occurred one time in our great country with the Rockefella's, Carnegie,s, etc. That was the build up before the great stock crash in 1929.

Our family life is broken with two income families trying to keep up with a mortgae that will eventually default. I never see the billionaires complaining cause they have so many paid lobbyists in Washington looking to take their money. This country is in a deep crisis and when the lower clas starts to see their retirement money decrease in 401ks there finally will be a change.

Sivaram,Again, you contradict yourself. I guess you're not aware thatMussolini himself once observed that fascism might more properly be labelled corporatism, because it is the alliance of big government and big business.

I probably did make a mistake however by casually calling the new model "State Capitalism" because, frankly, I don't know what to call it. I suppose they'll have to come up with a new name for it.

My point was simply that the corporate fascist model of unregulated capitalism as practiced by the US is proving a failure; just like the failed economic model of central planning by the state as practiced by the old Soviet Union.

China, for example, seems to have assessed these failures and is attempting to create a more optimal and balanced system by essentially saying "let the businessmen run the businesses - but they will not run the government".

You say "lets talk in 5 years". Well you are right of course that time will tell. But suppose you said the same thing 5 years ago? Who do you think is better off now: countries building real wealth on the back of a real economy based on manufacturing and natural resources and with massive forex reserves and trade surpluses or one where dubious financial engineering has been allowed to dwarf the real economy, is drowning in debt and in which the only apparent plan for "growth" is the attempt to create even more debt?

No matter how you want to rationalize it, it is not in the best interest of a nation to have the fortunes of a small elite and those of the vast majority to be heading in dramatically opposite directions.

IMO, we need a flight to simplicity. It seems to me that a good first step in aligning management with shareholder would be to eliminate risk free equity/derivatives (e.g. options) compensation. Also, tax incentives might help. In particular, a tax rebate for management on dividends on the companies shares if the shares were bought with the managers own savings (and I do mean savings, NOT leverage). That way, management would at least need to earn real profit and be on the hook for a declared dividend (benefiting all shareholders), before they see anything themselves. Also, maybe reducing/eliminating the capital gains tax on profits generated by the sale of shares bought with the managers own money and held for longer than some set period of time (e.g 2 yrs? 5 yrs?).

This is OT but going back to what is going on with ABK and MBI, since the annoucnements today by moodys and s&p, it seems that these companies are much more likely to lose their AAA than yesterday. Their low market caps will make it almost impossible to raise the necessary funds - unless someone is willing to pay much more than market price.

You correctly predicted AGO would have a bumpy ride if this were to happen. Any changes in thoughts on AGO? I, think this is very positive for them and am seriously considering putting more money in AGO as I think MBI and ABK have at this point irreversably damaged their reputations regardless of what happens and will never be looked upon as safe insurers again. Buffett will now swoop in big time and make a lot of money in munis FSA will thrive too. I still think that AGO will be able to earn out any losses that may occur in the Helocs Prime and Subprime RMBS's.

Also, if ABK and/or MBI do lose their AAA, is there any way for bondholders of current munis to pay FSA, Buffett or AGO an additional fee to wrap their bonds? I think it might be an economical transaction for them, but would doubt you can get a diverse group of bondholders to agree to this so I think this will never happen, just thowing thoughts out to see what sticks.

Sorry about not replying to some of your comment anon. One of my investments, Ambac, blew up in my face so that has been keeping me occupied.

AccruedInterest, it looks Ambac, MBIA, FGIC, et al, are going to be downgraded to AA. Can you share your thoughts on the implication of this on the bond market, as well as the future of companies like Ambac? Thanks...

Doesn't he value his reputation at all? Wouldn't you rather be well respected and have 50 million in wealth than be despised and have 500 million? How is life much better with 500 million than with 50 million?

Sivram,Sorry to hear that. Hope it wasn't too big a position. If you're interested, Barry Ritholtz had a good post today on how Ambac turned a great, low-risk business into a potential titanic.

An excerpt...

[Ambac]"used to have a nice little business going. They wrote insurance on bonds that cities, states and municipalities issued. ... A lovely, low risk business, with little defaults and a steady revenue stream. At one point in time, AMBAC had the highest revenue per employee on the planet.

That situation was obviously intolerable. So they brought in the financial engineers. Hey, we should be issuing insurance on Credit Default Swaps (CDS) -- the premiums are much much bigger than boring old munis!"

Thanks for the word of "condolescence" (if there is such a thing in investing :) ). It was a huge position for me and the biggest risk of my life but it's ok. It was a risk that I was willing to take and I'm not really sure the game is over yet. Going with AccruedInterest's favourite reference, ok, so the Empire Strikes Back... but... The Return of the Jedi still hasn't played in theaters--just my opinion ;) I just took my position only recently, knowing the risks, so it's fine...

I also don't agree with Barry Ritholtz (and others) who think the business strayed too far from their competence. I actually think structured products are the future and expect bond insurers to thrive in that field. The problem is, as Buffett pointed out, they didn't price things properly. It's no different than a mega-catastrophic insurer mispricing hurricane insurance and then running into serious problems...

Someone suggest eliminating options and things like that. That cannot be done and doesn`t make sense. In a free market, people will devise ways to transfer wealth. If people really thought executives were being paid too much, it is really up to the shareholders.

DIVIDENDS

As someone who does not like dividends (much worse from a tax point of view), this isn`t going to accomplish anything. First of all, companies that pay high dividends also have corporate governance issues.

Secondly, I would rather reinvest profits than pay it out so what happens to people like meÉ

Don`t forget that Warren Buffett--greatest investor of all time IMO--doesn`t pay dividends. It`s just not worth it.

First of all, I think China is going to be the next big economic power. But it is going to take a lot longer and they have serious problems that you are ignoring.

I have to admit that I'm bearish on China (same with India, Russia, and others that investors are tripping over themselves for). A lot of the wealth creation is an illusion. That's just an opinion but I believe in it strongly.

There is a massive stock market bubble that is goign to cause hundreads of billions of dollars in damage.

There is a huge property bubble that can cause huge unrest. An average citizen is increasingly being priced out of a home.

I also believe they have a manufacturing bubble. Many inefficent factories being propped up by the government.

You also seem to ignore the fact that a huge chunk of China's banking system (most of it owned by the government) has a very high non-performing loan rate. If you thought Japan had banking problems, China is going to be many times worse.

I'm not saying USA (or Canada--I'm in Canada) is paradise. No doubt you guys have a big problem with discrepancy in wealth between the lower classes and upper classes (I'm just working class so I know exactly what this problem is).

The great thing about a free market--even one that seems extreme at times--is that it rewards merit. Unlike China, where government connections largely play a role in, say, whether you get a zoning permit or are allowed to bid on a property, Americans are largely left to their own devices. I'm not saying it's perfect. But it is nowhere near as bad as in China.

If you are really concerned with Americans being in too much debt, the most powerful thing you can do is to introduce a course in High Schools on personal finance. If people knew how much more you pay by going into debt, they likely will re-think before buying something they can't afford.

----

(oh, I thought the pro-government-healthcare Americans were supposed to be jealous of Canada's healthcare system. Whose dumb idea was it to use France as a model? just/kidding :) )

You do not mention Countrywides stock repurchases,or Mozillo's stock sales which yielded him about $650 MM.If he was not motivated by greed why was he exercising his options and selling stock at the same time the corporation was buying thatt stock at premium prices?

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"Lets say for example that there are 6 open slots. Guess what? There are 6 people running, so as long as they get one "In Favor" vote, they are in. Unless there is a hostile takeover, guess who picks ALL SIX NOMINEES? Management, aka the CEO. If the guy is smart enough to find the office building, then he is smart enough not to pick anyone who is going to give him a hard time."

Possibly I'm not as schooled on the machinations that take place behind corporate closed doors as you are but I have read a few books.

And "Barbarians At The Gate" articulates the situation inside RJR pretty much just as you have described.

The Fed has had for many years the power to create any amount of IBDD’s (Interbank Demand Deposits). There are no reserve or reserve-ratio restrictions on the credit-creating capacity of the 12 Federal Reserve Banks.

The newly created IBDD’s can be put at the disposal of any bank in the System through the “discount window” or in the present situation the Term Auction Facility. These borrowed deposits are not only money to the recipient bank, they also become a part of the legal reserves of the System. And therein lies a limitation.

The Fed cannot increase the legal reserves of the System without creating the basis for a multiple expansion of the money supply (multiple in terms of the incremental reserves).

One dollar of borrowed reserves from the TAF provides the same legal-economic base for the expansion of money as one dollar of non-borrowed reserves (vault cash & IBDDs). The fact that advances have to be repaid in 28 days is immaterial. A new advance can be obtained, or the borrowing bank replaced by other borrowing banks. The importance of controlling borrowed reserves is indicated by the fact that at times during the TAF program (1/16/08) nearly all legal reserves are borrowed, i.e., total legal reserves are approximately equal to total borrowed reserves.The Fed can, and does, offset domestic borrowings & foreign exchange swap lines with open market selling operations, thus eliminating any net increase in bank legal reserves.

Therefore, with the rescue operation of the TAF’s dimension, it has offset TAF auction credit with open market selling operations of U.S. Treasury Bills, see: (-) 61,659 (H4.1) 1/10/08, as well as Treasury Bill redemptions (which decrease the assets on the Federal Reserve’s balance sheet -- by reducing the SOMA portfolio), and reverse repos (from non-U.S. banks, etc,) to drain the added reserves from TAF borrowings (H4.1).

Note: Commercial banks PAY for excess reserves both in the inter-bank market (direct/correspondent or brokered, etc.), or acquire reserves via open market operations from the “trading desk”.

Commercial banks also PAY the Reserve bank for borrowed reserves from either the discount window or the Term Auction Facility. A significant portion of IBDD's are always bought.

Prior to Jan 2003 the discount rate or adjustment credit, etc. averaged c. 25-50 basis points below the fed funds rate. Then the problem was that the commercial banks flaunted the Board’s rule that advances should not be used for profit. & the profit proclivities of the commercial banks eliminated any stigma to the borrowing.

Afterwards, the discount rate became a penalty rate designed to minimize discount window borrowing in times of rising interest rates and rising inflation.

Hence the new cost differential discouraged excessive advances that are made regardless of (1) their purpose or (2) the reserve position of the borrowing banks. I.e., because all of these institutions are able to borrow in the fed funds market at lower costs.

However, the 1/14/08 TAF auction’s stop-out rate of 3.95% was effectively the same as the “trading desks” one-day target repo rate on Treasuries, i.e., the one-day cost-of-carry on Government Securities, i.e., lower than the (OIS) overnight indexed swap rate (expected FFR the next 30 days). Recognize here that the repo target rate is the true monetary “policy instrument”.

Thus the FOMC has maximized the funding supplied to the inter-bank market by (1) accepting a wider variety of “eligible paper” (assumption of risk); using the Federal Reserve’s standard evaluation & haircut procedures, & (2) extending the borrowing period; eventually driving down the market price to counter-parties. Essentially, the “trading desk” substituted virtually all non-borrowed reserves with borrowed reserves at the TAF (injecting its’ maximum liquidity to inter-bank lending). It was a brilliant move by the FED

In contrast the FOMC targets the federal funds rate (at a higher 4.25%), nominally the rate banks charge each other on overnight loans of deposits at the Fed. The FF market is where un-collateralized (unsecured) inter-bank loans (excess reserves) are lent & borrowed for short duration. The daily federal funds transactions in comparison to the Government Securities market are a trivial amount.

The H4.1 shows both factors supply & absorbing reserves. Modern Money Mechanics demonstrates both commercial and the reserve banks balance sheet changes which affect the “free” legal reserves owned by the depository institutions on the H4.1.

As a system (on the H4.1), Term auction credit has replaced non-borrowed reserves (interbank demand deposits at the Reserve Banks) plus vault cash (with minor exceptions). But if an individual commercial bank has independent reserve requirements, why would a bank change the reserves it holds to be reserves it must pay for at the TAF? I'm missing something?

You are exactly correct. But remember that most banks no longer face binding statutory reserve requirements -- increasing amounts of vault cash (including ATM networks) plus retail deposit sweep programs (e.g., my articles on this in our Review) have wiped aside such binding requirements. A further advantage of the auction facility is the liberal rules regarding the types of assets that the discount window folks will accept as collateral -- including (gulp) certain CDOs. Such securities are not purchased by the Open Market Desk as it supplies nonborrowed reserves. The difference in the type of securities that the Fed will accept at the Window and at the Desk perhaps is the answer.

The implementation of the Term Auction Facility has vastly accelerated the enactment and exercise of the Financial Services Regulatory Relief Act of 2006 provisions.

As a system (on the H4.1), Term auction credit has replaced non-borrowed reserves (interbank demand deposits at the Reserve Banks) plus vault cash (with minor exceptions).

The commercial banking system is essentially operating on a prudential or liquidity reserve basis (years before the Acts anticipated launch in Oct 2011). That is, only vault cash & borrowed reserves are utilized.

Using what economists call the "Lombard Facility" (just another name for the federal funds bracket racket or lending & deposit rates), the Central Bank provides advances at a penalty rate (the expected rate level above overnight market interest rates).

If the Federal Reserve had the authority to pay interest on excess reserve balances and contractual clearing balances (two types of balances that depository institutions hold voluntarily at Reserve Banks), and did so, that interest rate would act as a minimum for overnight interest rates, then we would be at that stage.

@flow5Thank you very much for sharing R.G. Anderson's enlightening and candid email response.

@Accrued InterestPlease let us know you're not sick or something, but merely busy or resting.Otherwise, I'll have to find out your real name in order to add it to the prayer list this Sunday for those "in prison or missing".Best,Dave

Agreed, but I would add that this is a moral problem. Morality, as defined by Kant's definition of morality -- (see: http://plato.stanford.edu/entries/kant-moral/ for more detail) propose a rule, make that rule for all humanity to live by, and then see if society works or breaks down. With the moral rule proposed by many CEO's -- "I'll take what I want regardless of if I add value" -- how would this rule impact all of society? With this "looking out for me only" rule, society would break down, everyone would lie, cheat & hoard, and be unconcerned with working and producing value. Capitalism needs to be morally driven by the law: "People are rewarded in accordance with their merit." This under Kant's definition works for society -- people are motivated, value and wealth are created.

Your line of attack on incentives is an important one. Hopefully there is a fix for it. But, I am still suprised to find someone so intelligent and versed in economics to be such a purist with regard to capitalism. It is what we have and it will continue to evolve. But, to pretend that it is inherently good (incentives to work toward socially beneficial goals) is just wrong. It's goal is money and always more of it. Many successful companies have products or services that are a detriment to our society. They may not last long, but it is capitalism that feeds their existence. Capitalism has no loyalty to the consumer or to the worker, only to the shareholder. Yes, it is how jobs and products and services are created in this system. But, it is only regulation that ensures some of those social benefits you talk about. You need only to look where regulation does not exist to see this, case in point China. Capitalism will even sacrifice the long term goals of a company for short term gains. Here I picture a family going through foreclosure and the maxed out consumer. Blaming Mozillo or the compensation committee for the results of capitalism is like blaming Bush for the results of neoconservative policy. Yes, errors were made and they should be held accountable. But, they are not the root of the problem. Without checks and balances it all goes to hell.

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I oversee taxable bond trading for a small investment management firm. Opinions expressed on this website may not reflect the opinions of my employers. Strategies described here should not be taken as advice, and may not be the strategies being used for my clients. Take this website as the egotistical ramblings of a bond geek and nothing more. E-mail is accruedint *at* gmail.com or find on Facebook.